Question

Explain the process of working of Investment Multiplier, for a hypothetical economy with Marginal Propensity to Consume (MPC) as 0.8 and Incremental Investment as ₹ 2,000 crore.

Hint:

Each round, 80 percent of new income is spent again. Income rises by 2,000 + 1,600 + 1,280 + ... = Rs. 10,000 crore, so the multiplier is 1/(1 - 0.8) = 5.

Answer 1

Step 1: Recall the idea behind the multiplier:
The investment multiplier works on one idea. The expenditure of one person is the income of another person.
So when investment rises, income rises by a larger amount through repeated rounds of spending.

Step 2: List the given data:
Marginal propensity to consume: MPC = 0.8. So 80 percent of every extra rupee of income is spent, and 20 percent is saved.
Incremental investment: change in investment = Rs. 2,000 crore.

Step 3: Round 1:
The investment of Rs. 2,000 crore becomes income of Rs. 2,000 crore for the producers of capital goods.
They spend 0.8 of it, which is Rs. 1,600 crore, and save Rs. 400 crore.

Step 4: Round 2 and later rounds:
The Rs. 1,600 crore spent is received as income by others. They spend 0.8 of it, which is Rs. 1,280 crore, and save Rs. 320 crore.
In round 3, income is Rs. 1,280 crore, consumption is Rs. 1,024 crore and savings are Rs. 256 crore. The rounds go on, and each round is smaller than the one before.

Round	Increase in investment (Rs. crore)	Increase in income (Rs. crore)	Increase in consumption (Rs. crore)	Increase in savings (Rs. crore)
1	2,000	2,000	1,600	400
2	-	1,600	1,280	320
3	-	1,280	1,024	256
...	...	...	...	...
Total	2,000	10,000	8,000	2,000

Step 5: Add up all the rounds:
Total increase in income is 2,000 + 1,600 + 1,280 + ... = Rs. 10,000 crore.
Total increase in consumption is Rs. 8,000 crore and total increase in savings is Rs. 2,000 crore. The total saving equals the original investment, which shows the economy has settled.

Step 6: Find the multiplier:
The multiplier is the change in income divided by the change in investment.
\[ K = \frac{1}{1 - MPC} = \frac{1}{1 - 0.8} = \frac{1}{0.2} = 5 \]
Check: 10,000 / 2,000 = 5. Both ways give the same value.

Final Answer:
An investment of Rs. 2,000 crore raises national income by Rs. 10,000 crore, which is 5 times the increase in investment. \[ \boxed{K = 5,\ \Delta Y = \text{Rs. } 10{,}000 \text{ crore}} \]